Openness And Optimal Monetary Policy
Source: European Central Bank
The authors show that the composition of imports has important implications for the optimal volatility of the exchange rate. Using input-output data for 25 countries they document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. They build a business cycle model of a small open economy to discuss how the problem of the optimizing policy-maker changes endogenously as the composition of imports and of final demand are altered. Contrary to models where steady state trade openness is entirely characterized by home bias, they find that trade openness is a very poor proxy of the welfare impact of alternative monetary policies.